LCNB CORP - Quarter Report: 2007 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.   20549

FORM 10-Q

(Mark One)

(  X  )

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

 (      )

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the transition period from

  to  

Commission File Number 000-26121

LCNB Corp.

(Exact name of registrant as specified in its charter)

Ohio

 31-1626393

(State or other jurisdiction of

(I.R.S. Employer

incorporation or organization)

Identification Number)

2 North Broadway, Lebanon, Ohio   45036

(Address of principal executive offices, including Zip Code)

(513) 932-1414

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

.                                                 [X] Yes         [  ] No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):  

[  ] Large accelerated filer          [X] Accelerated filer          [  ] Non-accelerated filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

.                                                 [  ] Yes         [X] No

The number of shares outstanding of the issuer's common stock, without par value, as of October 26, 2007 was 6,345,486 shares.

LCNB Corp.

INDEX

Page No.

Part I - Financial Information

Item 1.      Financial Statements

Consolidated Balance Sheets -

September 30, 2007, and December 31, 2006

1

Consolidated Statements of Income -

Three and Nine Months Ended September 30, 2007 and 2006

2

Consolidated Statements of Comprehensive Income -

Three and Nine Months Ended September 30, 2007 and 2006

3

Consolidated Statements of Stockholders' Equity -

Nine Months Ended September 30, 2007 and 2006

4

Consolidated Statements of Cash Flows -

Nine Months Ended September 30, 2007 and 2006

5

Notes to Consolidated Financial Statements

6-16

Report of Independent Registered Public Accounting Firm

17

Item 2.      Management's Discussion and Analysis of Financial

    Condition and Results of Operations

18-28

Item 3.      Quantitative and Qualitative Disclosures about

   Market Risks

29

Item 4.      Controls and Procedures

30

Part II - Other Information

Item 1.      Legal Proceedings

31

Item 1A.   Risk Factors

31

Item 2.      Unregistered Sales of Equity Securities and Use of Proceeds

31

Item 3.      Defaults Upon Senior Securities

31

Item 4.      Submission of Matters to a Vote of Security Holders

31

Item 5.      Other Information

31

Item 6.      Exhibits

32

Signatures

33

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-4-

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 (Unaudited)

Note 1 - Basis of Presentation

Substantially all of the assets, liabilities and operations of LCNB Corp. ("LCNB") are attributable to its wholly-owned subsidiaries, LCNB National Bank (formerly Lebanon Citizens National Bank) (the "Bank"), and Dakin Insurance Agency, Inc. ("Dakin").  The accompanying unaudited consolidated financial statements include the accounts of LCNB, the Bank, and Dakin.

The unaudited interim consolidated financial statements, which have been reviewed by J.D. Cloud & Co. L.L.P., LCNB’s independent registered public accounting firm, in accordance with standards established by the Public Company Accounting Oversight Board, as indicated by their report included herein and which does not express an opinion on those statements, have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and the rules and regulations of the Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, the unaudited interim consolidated financial statements include all adjustments (consisting of normal, recurring accruals) considered necessary for a fair presentation of financial position, results of operations, and cash flows for the interim periods, as required by Regulation S-X, Rule 10-01.

Certain prior period data presented in the financial statements have been reclassified to conform with the current year presentation.

Share and per share data have been restated to reflect a 100% stock dividend, accounted for as a stock split, declared by the Board of Directors on April 10, 2007 and paid on May 10, 2007 to shareholders of record on April 25, 2007.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

Results of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the full year ending December 31, 2007.  These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements, accounting policies, and financial notes thereto included in LCNB's 2006 Form 10-K filed with the SEC.

Note 2 – Acquisition

On August 13, 2007, LCNB signed a definitive agreement to acquire Sycamore National Bank (“Sycamore”) in a stock and cash transaction valued at approximately $9.7 million.  Sycamore operates two full–service branches in Cincinnati, Ohio.  As of September 30, 2007, Sycamore had total assets of $49.1 million, deposits of $44.2 million, loans of $44.0 million and shareholders’ equity of $4.6 million.

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 2 – Acquisition (continued)

Under the terms of the agreement, Sycamore will be merged with and into the Bank and Sycamore’s two offices will become branches of the Bank.  Each share of Sycamore common stock will be exchanged for, at the election of each shareholder, $33.75 in cash, 2.444 shares of LCNB common stock, or a combination of cash and shares.    A Sycamore shareholder’s election to receive cash or stock is subject to allocation procedures that will ensure that, in the aggregate, 50% of the shares of Sycamore common stock will be exchanged for cash and 50% will be exchanged for stock.  Subject to regulatory approvals and Sycamore shareholder approval, the transaction is anticipated to be completed during the fourth quarter, 2007.  

Note 3 - Earnings Per Share

Basic earnings per share is calculated by dividing net income by the weighted average number of common shares outstanding during the period.  Diluted earnings per share is adjusted for the dilutive effects of stock options.  The diluted average number of common shares outstanding has been increased for the assumed exercise of stock options with proceeds used to purchase treasury shares at the average market price for the period.  The computations were as follows for the three and nine months ended September 30 (dollars in thousands, except share and per share data):

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 4 - Investment Securities

The amortized cost and estimated fair value of available-for-sale investment securities at September 30, 2007 and December 31, 2006 are summarized as follows (in thousands):

Information concerning securities with gross unrealized losses at September 30, 2007, aggregated by length of time that individual securities have been in a continuous loss position, is as follows (in thousands):

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 4 - Investment Securities (continued)

The decline in fair values is primarily due to increases in market interest rates.  Unrealized losses on securities at September 30, 2007 have not been recognized into income currently because management has the intent and ability to hold the securities for a period of time sufficient to allow for any anticipated recovery in fair values.  Therefore, no individual declines are deemed to be other than temporary.

Note 5 - Loans

Major classifications of loans at September 30, 2007 and December 31, 2006 are as follows (in thousands):

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 5 - Loans (continued)

Changes in the allowance for loan losses for the nine months ended September 30, 2007 and 2006 were as follows (in thousands):

Charge-offs for the nine months ended September 30, 2007 and 2006 consisted primarily of consumer loans, and checking and NOW account overdrafts, but also included some residential and commercial real estate loans.  

Non-accrual, past-due, and restructured loans as of September 30, 2007 and December 31, 2006 were as follows (in thousands):

Non-accrual loans at September 30, 2007 consisted of two home equity line of credit loans, one residential real estate mortgage loan, and one commercial real estate mortgage loan.  Non-accrual loans at December 31, 2006 consisted of a residential real estate mortgage loan and a home equity line of credit loan made to the same borrower, and a loan secured by farmland.  The residential real estate mortgage loan and home equity loan were paid current during the second quarter, 2007 and the loan secured by farmland was paid in full during the second quarter, 2007.  

The commercial real estate mortgage loan included in non-accrual loans at September 30, 2007 had a balance of $1,277,000 at that date.  This loan was previously classified as a restructured loan and was removed from that classification during the fourth quarter, 2006 because it was current at that time and had a market interest rate.

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 5 - Loans (continued)

Loans past-due 90 days or more and still accruing interest at September 30, 2007 and December 31, 2006 consisted of consumer loans and residential mortgage loans.  

Restructured loans at September 30, 2007 consisted of a commercial loan secured by commercial real estate.  It was previously classified as restructured and was removed from that classification during the fourth quarter, 2006 because it was current and had a market interest rate.  It was returned to the restructured classification during the second quarter, 2007 because of the Bank’s agreement to waive the required principal payments for a period of one year, pending the sale of the underlying collateral property.

Real estate acquired through foreclosure was $757,000 and $752,000 at September 30, 2007 and December 31, 2006, respectively, and is included in “other assets” in the consolidated balance sheets.  Real estate acquired at September 30, 2007  and December 31, 2006 consisted of one single-family residential home.

Mortgage loans sold to and serviced for the Federal Home Loan Mortgage Corporation ("FHLMC") are not included in the accompanying balance sheets.  The unpaid principal balances of those loans at September 30, 2007 and December 31, 2006 were $40,809,000 and $42,431,000, respectively.  Loans sold to the FHLMC during the three and nine months ended September 30, 2007 totaled $511,000 and $2,517,000, respectively, and $346,000 and $2,471,000 during the three and nine months ended September 30, 2006, respectively.

Note 6 – Borrowings

During March, 2007, LCNB obtained a $5 million advance from the Federal Home Loan Bank of Cincinnati.  The term of the advance is ten years and interest is payable monthly at a fixed rate of 5.25%.  The loan is secured by a blanket pledge of LCNB’s 1-4 family first lien mortgage loans.

At September 30, 2007, short-term borrowings included U.S. Treasury demand note borrowings of approximately $2,805,000.  The interest rate on the U.S. Treasury demand note borrowings is variable and was 4.52% at September 30, 2007.

At December 31, 2006, short-term borrowings included federal funds borrowed of $14,100,000 and U.S. Treasury demand note borrowings of approximately $1,264,000.  The interest rate on federal funds borrowed was 5.25% and the interest rate on the U.S. Treasury demand note borrowings was 5.04% at December 31, 2006.  

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 7 – Regulatory Capital

The Bank and LCNB are required by regulators to meet certain minimum levels of capital adequacy. These are expressed in the form of certain ratios. Capital is separated into Tier 1 capital (essentially shareholders' equity less goodwill and other intangibles) and Tier 2 capital (essentially the allowance for loan losses limited to 1.25% of risk-weighted assets). The first two ratios, which are based on the degree of credit risk in LCNB's assets, provide for weighting assets based on assigned risk factors and include off-balance sheet items such as loan commitments and stand-by letters of credit. The ratio of Tier 1 capital to risk-weighted assets must be at least 4.0% and the ratio of Total capital (Tier 1 capital plus Tier 2 capital) to risk-weighted assets must be at least 8.0%.  The capital leverage ratio supplements the risk-based capital guidelines. Banks are required to maintain a minimum ratio of Tier 1 capital to adjusted quarterly average total assets of 3.0%.

For various regulatory purposes, financial institutions are classified into categories based upon capital adequacy.  The highest "well-capitalized" category requires capital ratios of at least 10% for total risk-based, 6% for Tier 1 risk-based, and 5% for leverage.  As of the most recent notification from their regulators, the Bank and LCNB were categorized as "well-capitalized" under the regulatory framework for prompt corrective action.  Management believes that no conditions or events have occurred since the last notification that would change the Bank's or LCNB's category.  A summary of the regulatory capital and capital ratios of LCNB follows:

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 8 - Commitments and Contingent Liabilities

LCNB is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers.  These financial instruments included commitments to extend credit and stand-by letters of credit.  They involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets.  Exposure to credit loss in the event of nonperformance by the other parties to financial instruments for commitments to extend credit and stand-by letters of credit is represented by the contract amount of those instruments.

LCNB uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.  Financial instruments whose contract amounts represent off-balance-sheet credit risk at September 30, 2007 and December 31, 2006 were as follows (in thousands):

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Unused lines of credit include amounts not drawn in line of credit loans.  Commitments to extend credit and unused lines of credit generally have fixed expiration dates or other termination clauses.  

Standby letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party.  At September 30, 2007 and December 31, 2006, outstanding guarantees of $2,276,000 and $1,674,000, respectively, were issued to developers and contractors.  These guarantees generally are fully secured and have varying maturities.  In addition, LCNB has a participation in a letter of credit securing payment of principal and interest on a bond issue.  The participation amount at September 30, 2007 and December 31, 2006 were approximately $6.3 million and $4.1 million, respectively.  The letter of credit balance is greater at September 30, 2007 because it was re-written in April, 2007.  At that time, LCNB’s participation amount was increased to the higher amount.  The new agreement has a final maturity date of January, 2012.

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 8 – Commitments and Contingent Liabilities (continued)

LCNB evaluates each customer's credit worthiness on a case-by-case basis.  The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation of the borrower.  Collateral held varies, but may include accounts receivable; inventory; property, plant and equipment; residential realty; and income-producing commercial properties.

At September 30, 2007, LCNB is committed under various contracts to expend approximately $720,000 to complete certain building and office acquisition and/or renovation projects and computer upgrades.  Management believes that LCNB has sufficient liquidity to fund its lending and capital expenditure commitments.

LCNB and its subsidiaries are parties to various claims and proceedings arising in the normal course of business.  Management, after consultation with legal counsel, believes that the liabilities, if any, arising from such proceedings and claims will not be material to the consolidated financial position or results of operations.  

Note 9 - Stock Options

Under the Ownership Incentive Plan (the "Plan"), LCNB may grant stock-based awards to eligible employees.  The awards may be in the form of stock options, share awards, and/or appreciation rights.  The Plan provides for the issuance of up to 200,000 shares.  As of September 30, 2007, only stock options have been granted under the Plan.  Options granted to date vest ratably over a five year period and expire ten years after the date of grant.  Stock options outstanding at September 30, 2007, as adjusted for the 100% stock dividend paid May 10, 2007, were as follows:

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 9 - Stock Options (continued)

The following table summarizes stock option activity for the periods indicated, as restated for the 100% stock dividend paid May 10, 2007:

At September 30, 2007, the aggregate intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) for options outstanding at that date and that were “in the money” (market price greater than exercise price) was approximately $10,000.  The aggregate intrinsic value at that date for only the options that were exercisable was approximately $8,000.  The intrinsic value changes based on changes in the market value of the Company’s stock.

The estimated weighted-average fair value of the options granted in the first quarter of 2007 and 2006 were $3.76 and $4.51 per option, respectively.  The fair value was estimated at the dates of grant using the Black-Scholes option-pricing model and the following assumptions:

Total expense related to options included in salaries and wages in the consolidated statements of income for the three and nine months ended September 30, 2007 were $6,000 and $18,000, respectively and $4,000 and $11,000 for the three and nine months ended September 30, 2006, respectively.  

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LCNB CORP. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

(Continued)

Note 10 – Employee Benefits

LCNB has a noncontributory defined benefit retirement plan that covers all regular full-time employees.  The components of net periodic pension cost for the three and nine months ended September 30, 2007 and 2006, are summarized as follows (in thousands):

LCNB previously disclosed in its consolidated financial statements for the year ended December 31, 2006, that it expected to contribute $975,000 to its pension plan in 2007.  A contribution of $1,004,000 was made to the pension plan on October 1, 2007.  LCNB expects to contribute another $52,000 during the fourth quarter, 2007.  

At September 30, 2007, accumulated other comprehensive income included $673,000, net of tax, of unrecognized net actuarial loss.

Note 11 – Recent Accounting Pronouncements

SFAS No. 157, “Fair Value Measurements,” was issued by the FASB in September, 2006.  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. generally accepted accounting principles, and expands disclosures about fair value measurements.  This statement does not require any new fair value measurements, but increases consistency and comparability in the use of fair value measurements and calculations.  This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007 and for interim periods within those fiscal years.  Management does not anticipate that the adoption of SFAS No. 157 will have a material effect on LCNB’s consolidated balance sheet or income statement.

SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” was issued by the FASB in February, 2007.  It permits, but does not require, corporations to measure many financial instruments and certain other items at fair value.  The decision to elect the fair value option is made individually for each instrument and is irrevocable once made.  Changes in fair value will be recorded in earnings.  SFAS No. 159 is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007.  Early adoption is permitted.  Management intends to adopt SFAS No. 159 in the year beginning January 1, 2008 and does not anticipate that adoption of this standard will have a material effect on LCNB’s consolidated balance sheet or income statement.

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 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

LCNB Corp. and subsidiaries

Lebanon, Ohio

We have reviewed the accompanying consolidated balance sheet of LCNB Corp. and subsidiaries as of September 30, 2007, and the related consolidated statements of income and comprehensive income for the three-month and nine-month periods ended September 30, 2007 and 2006, and the related consolidated statements of shareholders’ equity and cash flows for the nine-month periods ended September 30, 2007 and 2006.  These financial statements are the responsibility of the Company's management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of LCNB Corp. and subsidiaries as of December 31, 2006 (presented herein), and the related consolidated statements of income, shareholders' equity, and cash flows for the year then ended (not presented herein), and in our report dated February 21, 2007, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2006, is fairly stated in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ J.D. Cloud & Co. L.L.P.                                      

Cincinnati, Ohio

October 26, 2007

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations

Forward Looking Statements

Certain matters disclosed herein may be deemed to be forward-looking statements that involve risks and uncertainties.  Forward looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words and their derivatives such as “expects,” “anticipates,” “believes,” “estimates,” “plans,” “projects,” or other statements concerning opinions or judgments of the Company and its management about future events.   Factors that could influence the accuracy of such forward looking statements include, but are not limited to, regulatory policy changes, interest rate fluctuations, loan demand, loan delinquencies and losses, general economic conditions and other risks.  Such forward-looking statements represent management's judgment as of the current date.  Actual strategies and results in future time periods may differ materially from those currently expected.  LCNB disclaims, however, any intent or obligation to update such forward-looking statements.  LCNB intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Acquisition

On May 31, 2006, Dakin purchased the existing book of business of Altemeier Oliver & Company Agency, Inc. (“AOC”), an independent insurance agency located in Blue Ash, Ohio. The acquisition of AOC was accounted for using the purchase accounting method and the results of operations of AOC have been included in the consolidated financial statements of LCNB since the acquisition date.  The acquired assets consisted solely of a customer list intangible asset. This intangible asset is being amortized on a straight-line basis over a ten year period.

Results of Operations

LCNB earned $1,370,000 or $0.22 per diluted share for the three months ended September 30, 2007, compared to $1,506,000 or $0.23 per diluted share for the three months ended September 30, 2006.  The return on average assets (ROAA) for the third quarter, 2007 was 0.99% and the return on average equity (ROAE) was 10.47%, compared with an ROAA of 1.08% and an ROAE of 11.47% for the third quarter of 2006.  The decrease in net income for the third quarter, 2007 is primarily attributable to a decrease in net interest income and an increase in non-interest expense.

LCNB earned $4,365,000 or $0.69 per diluted share during the first nine months of 2007 compared to $4,724,000 or $0.73 per diluted share for the first nine months of 2006.  The ROAA and ROAE for the first nine months of 2007 were 1.07% and 11.28%, respectively.  The comparable ratios for the first nine months of 2006 were 1.16% and 12.09%, respectively.  The decrease in net income for the nine months ended September 30, 2007 is primarily attributable to a decrease in net interest income, an increase in the provision for loan losses, and an increase in non-interest expense.     

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Net Interest Income

Three Months Ended September 30, 2007 vs. 2006.

LCNB's primary source of earnings is net interest income, which is the difference between earnings from loans and other investments and interest paid on deposits and other liabilities.  The following table presents, for the three months ended September 30, 2007 and 2006, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resulting average yields earned or rates paid.

(1)

Includes nonaccrual loans, if any.

(2)

Income from tax-exempt securities is included in interest income on a taxable-equivalent basis.  Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.

(3)

The net interest spread is the difference between the average rate on total interest-earning assets and interest-bearing liabilities.

(4)

The net interest margin is the taxable-equivalent net interest income divided by average interest-earning assets.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table presents the changes in taxable-equivalent basis interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the three months ended September 30, 2007 as compared to the same period in 2006.  Changes not solely attributable to rate or volume have been allocated to volume and rate changes in proportion to the relationship of absolute dollar amounts of the changes in each.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Net interest income on a fully tax-equivalent basis for the three months ended September 30, 2007 totaled $4,621,000, a decrease of $138,000 from the comparable period in 2006.  Total interest expense increased $229,000, which was partially offset by an increase in total interest income of $91,000.  

The increase in total interest expense was primarily due to a 27 basis point increase in the average rate paid, which was primarily due to general increases in market interest rates, slightly offset by the decrease in average interest-bearing liabilities referred to above.

The increase in total interest income was due to a 13 basis point (one basis point equals 0.01%) increase in the average rate earned on earning assets and to a $14.0 million increase in average loans, partially offset by a $20.4 million decrease in average investment securities.  The increase in the average rate earned on earning assets was primarily due to general increases in market interest rates.  The decrease in average investment securities was used primarily to fund the growth in average loans.

The net interest margin decreased 7 basis points in the third quarter, 2007 compared to the third quarter, 2006. The lower margin reflects highly competitive market pricing conditions for both loans and deposits.  As a result, average deposit rates increased faster than average loan rates.

Nine Months Ended September 30, 2007 vs. 2006.

The following table presents, for the nine months ended September 30, 2007 and 2006, average balances for interest-earning assets and interest-bearing liabilities, the income or expense related to each item, and the resultant average yields earned or rates paid.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

(1)

Includes nonaccrual loans, if any.

(2)

Income from tax-exempt securities is included in interest income on a taxable-equivalent basis.  Interest income has been divided by a factor comprised of the complement of the incremental tax rate of 34%.

(3)

The net interest spread is the difference between the average rate on total interest-earning assets and interest-bearing liabilities.

(4)

The net interest margin is the taxable-equivalent net interest income divided by average interest-earning assets.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table presents the changes in taxable-equivalent basis interest income and expense for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to volume and rate changes for the nine months ended September 30, 2007 as compared to the same period in 2006.  

Net interest income on a fully tax-equivalent basis for the first nine months of 2007 totaled $14,207,000, a $238,000 decrease from the same period in 2006.  Total interest expense increased $1,285,000 and was partially offset by an increase in total interest income of $1,047,000.

The increase in total interest expense was due primarily to a 41 basis point increase in the average rate paid on interest-bearing liabilities.  The net interest margin decreased 7 basis points during the first nine months of 2007 compared to the first nine months of 2006 primarily due to competitive market pricing conditions for both loans and deposits and to a flat or inverted yield curve during much of the 2007 period.  As a result, average deposit rates increased faster than average loan rates.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The increase in total interest income was due to a 27 basis point increase in the average rate earned on earning assets, from 6.23% for the first nine months of 2006 to 6.50% for the comparable period in 2007, and to a $21.2 million increase in average loans, partially offset by a $19.7 million decrease in average investment securities.  The decrease in average investment securities was used to fund the growth in average loans.

Provision and Allowance For Loan Losses

The total provision for loan losses is determined based upon management's evaluation as to the amount needed to maintain the allowance for loan losses at a level considered appropriate in relation to the risk of losses inherent in the portfolio.  In addition to historic charge-off percentages, factors taken into consideration to determine the adequacy of the allowance for loan losses include the nature, volume, and consistency of the loan portfolio, overall portfolio quality, a review of specific problem loans, and current economic conditions that may affect borrowers’ ability to pay.  The provision for loan losses for the three months ended September 30, 2007 and 2006 was $75,000 and $66,000, respectively, and $158,000 and $100,000 for the nine months ended September 30, 2007 and 2006, respectively.  

Non -Interest Income

Three Months Ended September 30, 2007 vs. 2006.

Non-interest income of $2,117,000 for the third quarter of 2007 was $44,000 greater than for the same period in 2006 primarily due to the absence of a loss on abandonment of an ATM recognized during the 2006 period, which was netted against other operating income.      

Nine Months Ended September 30, 2007 vs. 2006.

Non-interest income of $6,220,000 for the first nine months of 2007 was $48,000 greater than for the same period in 2006 for primarily the same reason mentioned above.  In addition trust income increased $28,000 primarily due to executor fees received during the 2007 period.  Service charges and fees decreased $44,000 due to a decrease in non-sufficient fund charges, partially offset by an increase in check card income.

Non-Interest Expense

Three Months Ended September 30, 2007 vs. 2006.

Total non-interest expense increased $118,000 during the third quarter, 2007 compared to the third quarter, 2006, primarily due to an $18,000 increase in salaries and wages, a $35,000 increase in pension and other employee benefits, and a $59,000 increase in occupancy expense.  Pension and other employee benefits increased primarily due to an increase in pension costs and occupancy expense increased primarily due to maintenance and repair costs and increased utilities expense.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

Nine Months Ended September 30, 2007 vs. 2006.

Total non-interest expense increased $345,000 during the nine months ended September 30, 2007 compared to the same period in 2006 primarily due to a $163,000 increase in salaries and wages, a $59,000 increase in pension and other employee benefits, and a $129,000 increase in occupancy expense.  Salaries and wages increased primarily due to additional employees and routine salary and wage increases.  Pension and other employee benefits increased primarily due to an increase in pension expense.  Occupancy expense increased primarily due to increased maintenance and repair costs, rent expense for the land for the new Oakwood office (opened May, 2007), and real estate taxes for the Oakwood office.

Income Taxes

LCNB’s effective tax rates for the nine months ended September 30, 2007 and 2006 were 24.2% and 25.2%, respectively.  The difference between the statutory rate of 34.0% and the effective tax rate is primarily due to tax-exempt interest income from municipal securities and tax-exempt earnings from bank owned life insurance.

Financial Condition

The fair value of securities available for sale was $91.1 million at September 30, 2007, approximately $20.0 million less than at December 31, 2006.  The decrease was due to maturities and calls; no securities were sold during the first nine months of 2007.  These additional funds, along with a $5.0 million FHLB advance obtained in March, 2007, and a $19.8 million increase in total deposits were primarily used to pay down short-term borrowings, fund loan growth, and build liquidity through investments in federal funds sold and interest-bearing demand deposits.

The term of the $5.0 million FHLB advance is ten years and interest is payable monthly at a fixed rate of 5.25%.

The $19.8 million increase in total deposits is due to public fund deposits from local governmental entities, which increased $20.5 million.

Short-term borrowings at September 30, 2007 were $2.8 million, a $12.6 million decrease from the December 31, 2006  balance of $15.4 million.

Net loans outstanding at September 30, 2007 totaled $394.1 million, approximately $5.8 million greater than at December 31, 2006.  Commercial and industrial loans, commercial real estate loans, and residential real estate loans comprised most of the increase.

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LCNB Corp. and Subsidiaries

Item 2. Management's Discussion and Analysis of Financial Condition and Results of

Operations (continued)

The following table highlights the changes in the balance sheets. The analysis uses quarterly averages to give a better indication of balance sheet trends.